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Monday, February 11, 2013

The Problem With Accumulated Wealth

I can't remember the last day where I did not check my investment portfolio. I can't even make an educated guess. Even during the financial free fall days of Fall 2008, I still took a look to see how much money I was losing on that given day. There were days where it's been close, and I've realized late in the evening that I didn't check how well my investments did. But I've never forgotten to check on my brokerage accounts for an entire day.

It goes against most advice that the financial "pros" give you to not be constantly distracted by the ups and downs of the market, but I do it anyways. I'm not particularly sure why, because I barely ever trade my positions. And when I do, it's usually a buy order because I buy every month on my 2nd paycheck. But it got me thinking about the knowledge of where you stand, because for me, I can't stand not knowing.

Some of my friends think differently. After I found out about an online tool that can calculate your net worth (Mint, incredibly useful finance tool, by the way), I told a lot of my friends about it and a few of them responded positively in the moment, but weeks later when I asked them if they had set it up, they told me they hadn't. One friend in particular, I suspect, hasn't done it because I think he don't want to know. I've bugged him about it and he keeps putting it off. Not knowing is preferable to knowing. Ignorance is bliss.

This, I suspect, is one reason why it's so hard to get people to save money. People don't like reducing their life situation down to a number. Because money is potential energy, and everybody wants what money can buy, but money in and of itself is anathema when it's just sitting in a brokerage account. Because it can lose value. And that scares a lot of people.

I remember reading this news story a few years ago about some engineer in the Midwest who had died. He never made more than 50k per year in salary when he was working. And when he died, he left behind an estate worth 2 million dollars that he built up simply by investing in his company 401k and his own personal brokerage account. And the reason why it was so newsworthy at the time is because it was such an unfathomable amount of money for a person who had never really struck it rich. The concept of saving and investing is so alien to most people that an incident like that was so interesting. It's the ant and the grasshopper fable except this guy was the ant. He worked diligently and saved his money all his life and left behind a fortune.

But let's flip that fable on its head and change it so that, at the end of the story, this gigantic flood comes and wipes away the ant's stockpile of food. In that instance, the ant would look pretty foolish, wouldn't he?

When I first started investing (Summer 2007), I was so sure in my own investment strategy that I started hectoring my own parents (who were diligent savers, almost to a fault in my opinion) that they should change their strategy to match mine. Months later, I began to point at my recent success, which was far greater than theirs, as proof. And then my dad told me something that resonates with me to this day: "Yes, you've done very well so far. But what happens if the market takes a dive and your portfolio drops 40, 50, 60%. What then?"

I calmly told him that because I was invested so heavily in index funds, that if that happened, everybody would be suffering and the best course of action was to stay put and ride it out. A few months later, Lehman Brothers and AIG declare bankruptcy, triggering the financial crisis and sent the market into a frenzy. At the lowest point, my portfolio was down by over 70% (I was heavily invested in emerging markets, which got hammered even harder than the domestic market) from its peak a few months back. And I still didn't sell.

Eventually, markets bounced back and since then, I'm back to where I started on my initial investments. While my later investments did very well. Overall, I'm in the black from where I was in 2007, and I'm very glad I stuck with my beliefs and rode out the storm. But I didn't have much invested in 2008. It was just under 7k at the time. So when the markets tanked, while my relative losses were extraordinary, in absolute terms it was a modest loss.

4 years later, and my portfolio has swelled thanks to my full time job. I'm worth a lot more than I was back then. And I'm not sure whether my actions (or non-action, rather) would have stayed the same should a similar panic happen sometime in the near future. I have so much more to lose now than I did back then, and it's hard for me to say whether I'd still stay the course this time around.

This is the fundamental problem with accumulated wealth. Ever heard of the saying "the first million is the hardest"? For a person who starts out at 0 net worth, gets a job, saves and invests diligently, the time they spend getting to 1 million in investable assets is far greater than the time they'll spend getting to 2 million. But their portfolio could tank with the market at any time.

If a person was on the cusp of 1 million in the summer of 08, they would have seen their life savings halve 5 months later. The knowledge that that could happen, and the regret it would trigger is one of the biggest obstacles to saving money. Because spending money is fun, enjoyable, and there are always good memories attached to the things we've bought with our money (trip memories, funny stories, or something tangible that we can see/feel/use) but it's never fun to look at your portfolio on a down day and think "I could have gone to Rome with the money I lost today".

The threat of potential losses is too much to bear. So people spend their money freely in the present. Buying things that they receive immediately as opposed to saving for the nebulous and uncertain future.

5 comments:

Jay, you talk a lot about investing and I would be interested to know more. Do you own individual stocks, bonds or funds or a combination of all? What tools do you use to research your investments? Do you have DRIP's? Do you use a traditional brokerage or an online one? Those kinds of things

All of my money is invested in broad market stock ETFs and fixed income with the exception of the lone holding I have in Ford (which comprises about 2.7% of my entire portfolio). I'm not sure if there are any ETFs that offer DRIPs, but it doesn't matter to me because all of the funds I'm in are commission free iShares ETFs compliments of Fidelity (it's actually one of the reasons why I moved my account from Scottrade to Fidelity). But it's all managed online.

As for the tools, Google Finance is the one thing I really look at seriously. But that's just to do back-of-the-envelope calculations for individual companies that I never wind up buying, anyways. My investment philosophy is to match the market (except geared more toward small cap stocks rather than the total market). So that means pouring money into the funds as soon as I get it and not worrying about the ups and downs.

I don't see how you got that at all. Savings is, of course, deferred consumption but "the long run" doesn't apply to individuals because we also save assets to bequeath the fruits of our labor to our progeny.

The vast majority of Americans will live paycheck to paycheck and have almost nothing of financial value to pass down to their children, but that just makes investing easier for the people who are smart enough to save and invest for the long term, because it artificially depresses the value of stocks and bonds.

Your belief that quantitative easing increases spending is utterly ridiculous. It all depends on market sentiment. The biggest expansion of the Fed's balance sheet happened during the worst part of the recession, where demand (on all fronts, consumer, corporate, etc) dropped precipitously.

An increase in spending isn't a good thing when the vast majority of Americans don't save for the future. The only way this is sustainable is if the government does the saving for them (and redistributes its earnings via entitlement programs) or if the few Americans who do save save prodigiously enough to keep the economy robust.

I'm curious as to what you think should be the proper rate of saving at a national level. If every American (including the 1%) acted like the average American, inflation would run rampant and civilization, as we know it, would end in about 20 years.

"I don't see how you got that at all. Savings is, of course, deferred consumption but "the long run" doesn't apply to individuals because we also save assets to bequeath the fruits of our labor to our progeny."

Exactly. If you were transferring little pieces of paper with dead presidents on them just for the sake of it, then indeed you would be correct. But thats not what we do. We pass down these notes so that, one day, our children will exchange them for something desirable. There is no desire for currency itself.

"Your belief that quantitative easing increases spending is utterly ridiculous. It all depends on market sentiment. The biggest expansion of the Fed's balance sheet happened during the worst part of the recession, where demand (on all fronts, consumer, corporate, etc) dropped precipitously."

I agree that it depends on market sentiment. The expectations channel is the primary mechanism via which MP works its magic. Thats why, without setting an explicit target (like NGDPLT), large changes in the Federal Reserve's balance sheet will have small comparative effects.

"An increase in spending isn't a good thing when the vast majority of Americans don't save for the future. The only way this is sustainable is if the government does the saving for them (and redistributes its earnings via entitlement programs) or if the few Americans who do save save prodigiously enough to keep the economy robust."

You're confusing spending and consumption. Aggregate spending is NGDP, which consumption is just one particular component of.

"I'm curious as to what you think should be the proper rate of saving at a national level. If every American (including the 1%) acted like the average American, inflation would run rampant and civilization, as we know it, would end in about 20 years."

1) I don't think there is a "proper" savings rate. Keep nominal spending growing on a level path and let the market do its thing.

2) I'm curious as to why a low aggregate savings level would produce inflation if a central bank is targeting 2% inflation.

In fact, it would make their job even easier as lower savings would raise equilibrium interest rates.